Scapegoating and Firm Reputation

Abstract

Firms typically fire senior executives in response to performance failures. Often, however, the expected performance improvements fail to materialize, suggesting that some of the fired executives are scapegoats. In this paper, I propose a rational, reputation-based theory of scapegoating, whereby firms differ in their ability to identify the incompetent executives that cause failure and the market imperfectly observes firms’ ability. I show that scapegoating, defined as random firing by a low-ability firm, is an optimal, reputation-saving, value-maximizing strategy if firms care sufficiently about short-term value, which depends on reputation, and if reputation is sufficiently high to be worth sacrificing a competent executive for. I then consider that failure is caused by exogenous factors rather than incompetence and show that even firms that are perfectly able to distinguish between these causes will scapegoat to leverage their reputation if the market is sufficiently convinced that failure is caused by incompetence.

Keywords: scapegoating, reputation, signalling, boards of directors, senior executives and firm performance

JEL Classification: D82, L14, M51